Friday, January 25, 2008

• Bank stocks, after declining 10% in 2007, have started the new year off declining a further 3%, representing one of the largest share price declines in decades and perhaps the only one not led by major earnings collapses. Bank relative performance in 2007 was the third worst in the past 40 or 50 years with only 1979 and 1999 being worse, despite the banks recording operating earnings growth of 10% and return on equity of 21% in fiscal 2007.

• Bank stocks have very rarely ever underperformed the market two years in a row. In fact the bank index typically rebounds very sharply. In 1980 and 2000 following the very weak relative performance in 1979 and 1999 the bank index appreciated more than 30% in each of those years. It is very early in the year but thus far in 2008 the bank index is outperforming the market by 4%.

Bank Earnings & Profitability Solid

• Bank investors remain nervous despite the release of fourth quarter earnings where the banks’ total writedowns represented a very modest 1.3% of common equity. The two banks (BNS and NA) that were due to increase dividends in the fourth quarter did so, although increases were modest. The bank group reported return on equity in the fourth quarter of 20% with a fully loaded ROE of 16%. Canadian bank writedowns pale by comparison to a number of global players. Banks’ return on equity for fiscal 2007 was 21%, which compares very favorably with the 11% recorded by the six major U.S. banks.

• Negative sentiment from headline news and troubled U.S. Financials has more than offset any comfort investors may have received from the release of solid fourth quarter results by the Canadian banks and the confirmation of their low exposure to high-risk assets.

• Bank share prices have continued under pressure early in 2008, driven by fears of monoline insurance companies defaulting, recession fears, and concerns about overall financial market instability. The insurance monolines Ambac and MBIA may fall under the category “Too Big to Fail.” Also they may be able to manage their commitments in a run-off scenario.

Bank Dividend Yields Relative to Bonds - Levels Never Seen Before

• Despite Canadian banks’ low exposure to high-risk assets (Exhibit 6) including monolines (except for CIBC), high capital levels, high profitability, resilient earnings base and a very stable residential mortgage market, Canadian bank stock price declines have pushed up dividend yields relative to long Canada bonds to levels never seen before. The bank dividend yield at 4.2% or 1.05x relative to long bonds is 5.0 standard deviations above the mean (Exhibit 15). This is the highest relative yield by a wide margin. Even if we look at a chart back to 1956, bank dividend yields would be 3.8 standard deviations above the mean, much higher than the 1958 peak of 3.3 standard deviations above the mean.

• This is astonishing especially if you believe, as we do, that the probability of dividend cuts is negligible; in fact we continue to look for dividend growth of at least 8%-10% per annum over the next five years. Hence the Best Buying Opportunity in Decades.

Stress Testing Earnings for a Recession - Payout Ratio 52%

• We are stress testing bank earnings (Exhibits 7-10) for a recession again this year following our fiscal 2006 analysis. In this year’s stress testing we have become more aggressive in haircutting earnings, with similar results and conclusion. Banks can weather a recession with return on equity troughing in the 17%-18% range. If we cut 2008 earnings to recession levels, banks would be trading at a P/E multiple of 12.4x with a dividend payout ratio of 52%. Thus the current dividend levels are totally maintainable and defensible.

• Canadian banks are not, however, immune to the turmoil in financial markets, and we expect earnings growth will be very challenging in the first half of 2008 as the higher funding costs and cost of carry on the banks’ excess liquidity and capital puts pressure on interest margins. The prime BA spread declined 22 basis points (bp) in the fourth quarter to 139 bp, with partial recovery in the first fiscal quarter by an estimated 15 bp.

Trimming Earnings Estimates

• We are trimming our 2008 operating earnings estimates by 5% due to expected margin pressure in the first half of 2008 because of an increase in bank funding costs and a lag in repricing assets, as well as negative carry on the banks’ excess liquidity and capital. Our earnings and share price target adjustments are highlighted in Exhibit 1.

• The operating earnings decline excludes the CIBC pre-announced special first quarter charge of $1.6 billion after tax or $4.75 per share comprised of $1.3 billion on hedged CDO/RMBS (ACA) and $0.3 billion on unhedged CDO/RMBS portfolio.

Resilient Earnings - Dividend Increases to Continue

• The potential further writedowns for the Canadian banks are expected to be modest, with Exhibit 13 highlighting possible future writedowns that are readily absorbable in operating earnings, except for CIBC.

• Our overall earnings outlook remains solid, with earnings growth of 3% expected in 2008 and earnings growth expected to rebound to 15% in 2009. Return on equity for 2008 and 2009 is forecast at the 22% level, with Tier 1 capital ratios remaining extremely high in the 9.5%-10.0% range.

• We expect earnings in the first half of 2008 (Exhibit 12) to be weak, with first quarter earnings declining 5% year over year and return on equity remaining stellar at 21.2%. We expect the four banks that are due to increase their common dividends to do so this quarter, with BMO and CM dividend increases expected in the 4% range and TD and RY increases expected in the 8%-9% range. There is some uncertainty with respect to a CIBC dividend increase given the recent equity issue. Earnings momentum is expected to pick up in the second half as credit markets and funding costs stabilize. We expect the banks’ very high trough ROEs to be supportive of higher share prices and higher valuation.

Bank Share Prices Expected to Double

• On an absolute return basis we have no sells in the bank group and, as fear subsides in the market, we expect significant appreciation in bank stocks over the next few years. Bank stocks, we believe, can easily double in the next three, four, or five years at the outside. We remain overweight the banks.

P/E Multiple to Recover

• In terms of bank P/E multiples, we expect the stress testing of bank earnings in fiscal 2008 will result in P/E expansion and higher multiples, as they did in 2002 (Telco & Cable) and 1998 (Asia Crisis), and that the longer-term trend of expanding P/Es will continue.

• Bank P/E multiples declined in 2007 (Exhibit 18) from 14.5x at the beginning of the year, closing the year out at a low of 11.1x with a further decline to the panic bottom of 10.8x trailing earnings in early 2008 (January 21, 2008). We have been searching for the illusive bottom since the 11.5x trailing range, with the panic selling on January 21, 2008 (bank stocks down 4%-5%) perhaps being the bottom.

• The P/E bottom in the Telco & Cable debacle was 10.9x, with the Asia Crisis being 9.0x. It seems that P/E multiples have bottomed in early 2008 at a similar level to Telco & Cable. Following this bottoming in 2002, the P/E multiples ran up to 15.1x. We are looking for a repeat.

• Bank valuations on a yield basis relative to bonds, Pipelines & Utilities, Income Trusts, and the S&P/TSX Composite are all at unheard of levels.

• Reversion to the mean versus 10-year bond yields implies a 7.8% bond yield or 97% increase in the bank index. Bank dividend yields relative to TSX, Pipes & Utilities, and Income Trusts on reversion to the mean basis implies a bank index increase of 62%, 63%, and 38% respectively.

Recommend Aggressively Buying Bank Stocks

• We would be very aggressive buyers of bank stocks at these levels with the weakest Canadian banks having extremely strong fundamentals.

• We continue to believe the best long-term value and shareholder returns will be derived from the high revenue growth banks TD, RY, and BNS. These banks have high profitability, superior operating platforms, and solid growth prospects.

• It is no coincidence that the revenue-challenged banks CIBC, BMO, and NA got caught in 2007 as a result of going out of the risk curve in search of revenue and earnings. CIBC’s exposure to CDO/RMBS, BMO’s to SIVs and Commodity Trading, and NA’s involvement in non-bank ABCP were all divergent from the mainstream.

• A year ago we had all banks essentially trading at the same multiple, regardless of profitability, business mix, revenue growth, or strength of operating platforms, which was not normal. P/E convergence of this magnitude has occurred only half a dozen times in the past 40 years. However, the relative share price performance among the banks varied considerably in 2007, and we now have some divergence in P/E multiples, slightly greater than the historical means with severe overshoots possible.

• We are reinstating coverage of CIBC and maintaining our pre-restriction rating of 2-Sector Perform. CIBC is a trading buy (with some disclosure risk) based on a 35% share price decline from its high, deep P/E discount of 22% to the group, strong capital position post the equity issue, and potential resolution of the U.S. monoline debacle. If the U.S. regulators are able to help resolve the concerns surrounding Ambac and MBIA, no significant further writedowns would be likely, with some of this we believe currently priced in. In terms of the ACA-related writedown, we believe the risk is priced in, with some possibility that losses could be lower than expected depending on the ultimate fate of ACA and improvement in value of the underlying securities aided by significant Federal Reserve rate cuts.

• The retail bank (includes wealth management) of CIBC earned $7.31 per share in 2007, which would equate to $6.65 per share on a pro forma basis after the dilution from the recent equity issue. Thus CIBC is currently trading at an attractive 10.2x the diluted 2007 retail banking earnings, with no value attributable to the wholesale business.

TD and RY Remain 1-Sector Outperforms

• CIBC continues to be a higher risk bank than TD and RY, our long term core holding banks that we have 1-Sector Outperform ratings on.

Two analysts have weighed in with somewhat pallid outlooks for Canadian banks this morning.

Desjardins Securities analyst Michael Goldberg expects earnings to be flat (at least on a collective basis) this year, and for dividend growth to slow appreciably.

With banks tightening their purse strings and being restricted in access to structured credit, he believes further credit crunching is unavoidable, no matter how much central banks grease the wheel.

Mr. Goldberg expects more modest top line growth and worsening loan quality as a result. However, he expects things to improve in 2009, and sees upside, both in terms of stock prices and dividend growth.

"We continue to view bank stocks as a foundation for any Canadian equity portfolio for the dividend growth potential they provide over time," wrote Mr. Goldberg.

His top picks are TD, because it "has avoided the pitfalls of sub-prime mortgages and structured products in Canada and the US, while continuing to successfully build its Canadian and US franchises," and Scotiabank, because "in the current uncertain environment, steady performance is a good thing."

Over at RBC Dominion Securities, Andre-Philippe Hardy and his team write that they are "increasingly concerned over the economy and equity markets" because "these two factors could be material negative earnings drivers for all financial services stocks in Canada."

Like Mr. Goldberg, however, Mr. Hardy tempers his pessimistic short-term outlook with longer term optimism, saying Canadian banks and insurance companies should navigate choppy economic waters better than their global peers and that "the return from holding these stocks over the next two or three years could be attractive as a result."